Volatility Arbitrage

Question 1

What is Volatility arbitrage?

Answer 1

Trading by believing that volatility is not correctly priced in the asset (believe asset will be more or less volatile)

Question 2

What does Warren Buffet do regrading Volatility Arbitrage?

Answer 2

Buys deep OTM put options with long expiration dates as an hedge

Question 3

Factors that affect volatility:

Answer 3

Past volume, LT mean, Events, Liquidity

Question 4

Why is volatility so important?

Answer 4

There should be no arbitrage, so all models are delta hedged

Question 5

3 facts of volatility:

Answer 5

Persistent (autoregressive)
Mean reverting
Asymmetrical

Question 6

Is volatility easier to estimate than price?

Answer 6

Yes

Question 7

What is the volatility smile?

Answer 7

Prices are higher for highly volatile options ITM and OTM (higher risk)

Question 8

Is the volatility smile symmetric?

Answer 8

No, it is skewed to the negative side, since when market goes down, it goes down a lot, comparing to when it goes up

Question 9

Types of arbitrage in Volatility arbitrage

Answer 9

Options vs. Options (put-call parity)
Listed products (convertible bonds, structured products)
Volatility futures (VIX) or intermarket spreads (VIX vs V2X)

Question 10

How to arbitrage a package (bond + call) in volatility arbitrage?

Answer 10

If you believe there is misspricing, then buy both underlying and hedge bond with delta hedging

Question 11

What is the Delta of an option?

Answer 11

Sensitivity of option price to stock price.
When Delta -> 1: option is deep ITM
When Delta -> 0: option is deep OTM

Question 12

What is the Gamma of an option?

Answer 12

Second derivative of option price to stock price.

When Gamma -> 1: Option ATM, Delta = 0.5

When Gamma -> 0: Then Option either deep ITM or OTM and delta either 1 / 0

Question 13

What is the Vega of an option?

Answer 13

The options sensitivity to volatility
If Vega -> 0, then option deep ITM / OTM
If Vega -> 1, then option ATM (very sensitive to volatility)